Altria: Cigarette Volume Fell 11% in Q1, But Dividend Yield Now 8%

Company Update (MO US) (Buy)

Highlights

• Cigarette volume declines have accelerated; Marlboro lost share

• But Reduced Risk Products are not to blame, for now

• EPS still grew 5.0% in Q1 and guided to grow 3-6% this year

• Shares have fallen 14% in the past year; P/E is less than 10x

• We still see a 38% upside (14.5% p.a.), albeit with risks. Buy

Introduction

Altria reported Q1 2023 results on Thursday (April 27). Cigarette volume fell by 11% year-on-year, after an 8% decline the year before. Volume declines have accelerated, and Marlboro is losing share. The blame lies mostly with high inflation; Reduced Risk Products do not seem a large headwind at present. California’s ban on menthol cigarettes likely had only a marginal impact.

Group net revenues fell despite a 6.8% rise in the average Marlboro pack price, but Operating Income and Adjusted EPS grew thanks to lower costs, higher interest income and buybacks. Management still expects Adjusted EPS to grow by 3-6% in 2023. However, pricing and costs may both become more difficult, especially with Philip Morris set to start selling IQOS in the US in Q2 2024. We believe U.S. cigarette volume declines will accelerate structurally, but too slowly to meaningfully impact Altria’s earnings in the next few years.

Altria is a “value” stock with low investor expectations but also significant downside risks. At $47.51, shares have fallen 14% in the past year, and have a 9.7x P/E and a 7.9% Dividend Yield. We still expect a 38% return (14.5% annualized) by 2025 year-end. On balance, we reiterate our Buy rating on Altria, but will continue to monitor it closely.

Altria’s Accelerating Volume Declines

Altria’s cigarette volume fell by 11% year-on-year in Q1 2023, after an 8% decline the year before:

Altria Cigarette Volume Declines (Adjusted) (Since 2020)

Source: Altria company filings.

Volume declines have accelerated. Year-on-year decline rose from 10% to 11% in the last two quarters. Three-year stacked decline (relative to pre-COVID 2019) accelerated through 2022, from 14% in Q1 to 19% in Q4. CEO Billy Gifford attributed this to the impact of high inflation on consumers on the earnings call:

“Consumer discretionary income levels remained under pressure due to the active effect of higher inflation over the past year … the cumulative effects of inflation over the past several quarters continued to impact tobacco consumers’ discretionary income and tobacco industry volumes.”

U.S. cigarette industry volume also fell 9% year-on-year in Q1, but Altria’s volume decline continued to exceed the industry average.

Marlboro Losing Market Share Again

Altria is losing more market share. Its premium brand, Marlboro, had a U.S. retail share of 42.5% in Q1 2020. With the COVID-19 pandemic, this rose to around 43% during 2020, had fallen back to 42.6% by Q4 2021, and has been falling since Q3 2022. It fell another 20 bps sequentially to 42.0% during Q1 2023:

Altria U.S. Retail Share (Since 2020)

Source: Altria company filings.

Including its other brands, Altria’s total U.S. retail share was 49.2% in Q1 2020, stayed at around 49% through most of 2020-21, but has been falling since Q3 2022 and was down to 47.0% as of Q1 2023.

Management also attributed this to the impact of inflation, as CFO Sal Mancuso explained on the call:

“We believe some smokers today are trading down as a result of adverse financial conditions. We continue to see increased competitive activity in the discount segment, including multiple branded discount offerings priced at deep discount levels.”

Inflation’s impact was made worse by how some competitors are pricing “their discount brands at deep discount levels”.

Reduced Risk Products Not to Blame, For Now

Reduced Risk Products (“RRPs”) did not seem responsible for the recent volume decline.

E-Vapor is the main RRP category in the U.S., and its volume declined by 1% sequentially in Q1 2023. Altria attributed this to a decline in traditional multi-outlet and convenient channel volumes, “primarily” due to the FDA’s Marketing Denial Orders for both Juul and Imperial Brands’ myblu:

U.S E-Vapor Category Volume by Quarter (Since 2019)

Source: Altria results presentation (Q1 2023).

Nicotine Pouches is the other key RRP category and is growing fast. However, it still has a small base, and only an estimated 44% of its growth is sourced from cigarette users (while 45% is from traditional oral tobacco products). Total Oral Tobacco volumes grew only 1.0% year-on-year on a rolling-twelve-month basis in Q1 2023.

Altria estimates attribute all of the decline acceleration to macro, and almost none to more smokers moving to RRPs (“additional cross-category movement”):

U.S. Cigarette Industry Volume Decline by Component (Rolling 12 Months)

Source: Altria company filings.

California Menthol Ban Impact Likely Marginal

California’s ban on menthol cigarettes, part of a wider ban on flavored tobacco products that became effective last December, likely only had a marginal impact in Altria’s volume decline. (Altria stated it was too early to comment.)

One reason is that California was likely only 6% of U.S. cigarette volumes. In 2021, state tobacco tax figures implied total cigarette units of about 11.9bn ($1.71bn of gross tax on $2.87 per pack of 20), while the FTC reported a national volume of 190.2bn units – which meant California’s volume was 6% of the U.S. total. This ties Altria’s public comment back in 2017, after California raised its tobacco tax from $0.87 to $2.87, stating its volume contribution to the industry had shrunk from 7% to 5%. Industry cigarette shipments in California fell 18.8% in Q1 2023, 10 ppt more than the national decline, which means California’s ban likely contributed 0.6 ppt of additional headwind to the U.S. industry total.

Another reason is that at least some of the previous menthol volume appeared to have moved across to neighbouring Nevada, with Altria observing a 1.3 ppt jump in menthol’s retail share there in Q1 (to 37.4%).

Tobacco Industry: Cyclicality vs. Structural Change

Cigarette volumes are cyclical, and Altria’s volume declines had both accelerated and decelerated in the past 16 years:

Altria Cigarette Volume Declines (Adjusted) (2007-22)

NB. Figures adjusted for inventory movements. Source: Altria company filings.

The key question is whether the latest decline acceleration will prove to be cyclical or structural.

Certainly, much of the recent macroeconomic headwinds are cyclical.

However, cigarette retail prices have been rising above inflation for years and becoming less affordable, at least relative to previous years. Reduced Risk Products are also becoming increasingly attractive alternatives to cigarettes for existing smokers as technology advances. Altria’s upward revision of their estimate of U.S. cigarette price elasticity (from 0.30 to 0.35) this year, the first change in decades, was an acknowledgement of this reality.

Looking at the chart, one could argue that declines have been accelerating since 2016, with 2020-21 being a brief interruption caused by pandemic dynamics such as stay-at-home restrictions and government stimulus. Equally, one could argue that this was just part of a muti-year cycle and a mirror image of the stabilization in 2009-15.

Historic volume data also tells us nothing about two key factors. One is that the FDA may end up removing the two largest U.S. E-vapor products from the market as part of their PMTA (Pre-Market Tobacco Process Application) process, with British American Tobacco’s Vuse Alto still waiting for approval and Juul having received a rejection (it is challenging this in court). The other is that IQOS Heated Tobacco products had only been briefly and poorly marketed in the U.S. by Altria during 2019-21, but will be sold directly by Philip Morris from Q2 2024.

On balance, we believe U.S. cigarette volume declines will accelerate structurally, but too slowly to meaningfully impact Altria’s earnings in the next few years.

Altria Revenues Fell in Q1, But EPS Grew

Net Revenues After Excise in Altria’s Smokeable segment fell 1.4% year-on-year, even after a 6.8% rise in the average Marlboro pack price. However, Operating Companies Income (“OCI”) was flattish (up 0.2%) thanks to lower costs:

Altria Smokeable Financials (Q1 2023 vs. Prior Year)

Source: Altria results release (Q1 2023).

In Oral Tobacco, revenues and OCI both rose by a low-single-digit, despite volume and market share declines:

Altria Oral Tobacco Financials (Q1 2023 vs. Prior Year)

Source: Altria results release (Q1 2023).

Consumers are migrating from traditional oral tobacco, where Altria has a near-50% market share (by volume), to nicotine pouches, where it has a 25% market share. Philip Morris’s ZYN has maintained its 75%+ value share in Q1.

Group Revenues After Excise fell 1.2% year-on-year, but OCI was flattish (up 0.3%):

Altria Group P&L (Q1 2023 vs. Prior Year)

Source: Altria results release (Q1 2023).

Net Income rose 3.5% thanks to a lower Net Interest Expense (with higher interest income from higher rates and the IQOS payment from Philip Morris). Adjusted EPS rose more, by 5.0%, after buybacks reduced the share count by 1.8%.

Management reiterated its 2023 Adjusted EPS guidance of $4.98-5.13, which implies a year-on-year growth of 3-6%.

Pricing and Costs May Get More Difficult

Pricing and costs may both become more difficult in future quarters, reducing Altria’s ability to maintain positive earnings growth with weak or negative revenue growth.

Pricing is getting more difficult. Altria is making “adjustments” to counteract pressures on consumer budgets and competitor promotional spend, as CEO Billy Gifford explained on the earnings call:

“We also made a separate announcement making some adjustments to promotional spend in the marketplace ... What we are seeing were pockets of area where we felt like Marlboro menthol was under pressure and …. stepped-up promotional spend by a competitor in the menthol space. So, we’re making some adjustments there … Some of the other adjustments are related to … where we see the consumer under extreme economic pressure, and we’re making some adjustments within the Marlboro franchise on promotional spend to counteract and give them a place where they can continue to engage with Marlboro.”

Costs may become more difficult, as Altria will need to spend money to develop and market Reduced Risk Products, including E-vapor products from the pending NJOY acquisition as well as Heated Tobacco products it is developing on its own and with Japan Tobacco. Altria will be increasingly competing with Philip Morris, which already sells ZYN nicotine pouches in the U.S. and is set to start selling IQOS Heated Tobacco products too in Q2 2024.

On the positive side, Altria has raised retail prices for its On! nicotine pouches, up 7% sequentially and 32% year-on-year as of Q1. It also expects “volume declines to moderate over time as the macroeconomic environment stabilizes”.

Altria Valuation Reflects Low Expectations

At $47.51, Altria shares have fallen 14% in the past year:

Altria Share Price (Last 1 Year)

Source: Google Finance (30-Apr-23).

Investor expectations are low, reflected in Altria’s low valuation. Relative to 2022, shares have a 9.7x P/E and a 10.0% Free Cash Flow (“FCF”) Yield; 2022 included a $1bn cash payment from Philip Morris for the return of U.S. IQOS rights.

Relative to the midpoint of 2023 EPS guidance ($4.98-5.13), the P/E multiple is 9.4x.

The Dividend Yield is 7.9%, from a dividend of $0.94 per quarter ($3.76 annualized). The current dividend costs about $6.7bn a year, about 90% covered by 2022 recurring FCF of about $7.5bn. Management has an explicit target of raising its dividend by mid-single-digits annually, and this is likely achievable for the near term.

Net Debt / EBITDA was 2.1x at 2022 year-end, compared to a 2.0x target. Buying NJOY would cost $2.75bn but Altria is also due to receive about $1.7bn from Philip Morris in July as the final payment for the return of U.S. IQOS rights.

Management had a target for $1bn of share buybacks in 2023 (equivalent to 1.2% of the current market capitalization), but these have been suspended while the NJOY acquisition is pending.

Altria Stock Forecasts & Conclusion

We keep our forecast assumptions unchanged:

• 2023 EPS of $5.06, mid-point of outlook

• From 2024, Net Income growth of 3.5%

• Share count to fall by 1% in 2023 and 1.5% annually from 2024

• Dividend to grow 5% annually

• P/E at 9.5x at 2025 year-end

Our 2025 EPS forecast is unchanged at $5.58:

Illustrative Altria Return Forecasts

Source: Librarian Capital estimates.

With shares at $47.51, we expect an exit price of $53 and a total return of 38% (14.5% annualized) by 2025 year-end.

These figures reflect our base case, our view of what is most likely to happen. However, there are significant tail risks. On the negative side, Philip Morris may take share in the U.S. market quickly and significantly from 2024; on the positive side, there will be significant upside if the U.S. cigarette market remains undisrupted.

On balance, we reiterate our Buy rating on Altria, but will continue to monitor it closely.

Ends

Stocks mentioned: MO 0.00 PM 0.00 BTI 0.00. We are long PM.